I HOLD THIS TRUTH TO BE SELF-EVIDENT, THAT A DEBT CRISIS CANNOT BE RESOLVED WITH MORE DEBT

Friday, October 10, 2008

Designed To Fail

I have mentioned this in the past, but given current events it bears repeating: Credit Default Swaps (CDS) are instruments that do much more damage to the "real" economy than good. Beyond more esoteric reasons, there is a very simple observation; in previous downcycles bankruptcies acted to "re-boot" the economy through debt destruction. Once the obligation was written off, it disappeared for good and did not encumber the economy - as a whole - any further.

That's no longer the case because the existence of CDS's means the debt obligation stays in the system intact, even though it may no longer be the original debtor's obligation but encumber the CDS issuer/writer. In fact, with multiple contracts having been written against a single issuer or index the total obligation is multiplied several-fold.

Result? No easy and fast catharsis through crisis, one of the most valuable aspects of market capitalism.

According to ISDA, the derivatives dealers' association, there were $54.6 trillion (yes, with a "t") of CDS outstanding globally as of mid-2008, a slight decline from $62.2 trillion at the end of 2007, but up almost 100-fold from just seven years ago. And if I hear the argument "it's only notional" once again, I will very casually say two words: counterparty risk. And it's not as if I haven't been screaming (almost obscentities) about them for the past two years...

Mark my words: there is more to this crisis that has not fully unfolded yet.

Hel,Do you know the difference in treatment of CDS buyers who own the covered bad debt and those who don't? Do they both collect the same payout? Are owners of the bad debt forced into the auctions along with non-owners and do you know how the auctions work?

Speaking of metals, someone talk me off the proverbial ledge. I've always been anti-gold. Its a ridiculous element. But I'm starting to get panicky about the US$ (thanks Edwardo!).... and everyone else is doing it... and its malleable..

I've been informally studying the "credit default swaps" market for some time. I've read that there are $58 trillion of these outstanding, a figure close to the one you use but except for being very large I suspect we don't know. Though some are off setting many may be built on leverage and unreserved for by the underwriter.

What will happen as a result of the Lehman auction today and similar events is that those solid institutions that underwrote CDS contracts which they than turned around and hedged with an off-setting CDO will still be obligated contractually for the CDO they underwrote while losing their protection to a bankrupt counter-party. They will than have unhedged exposure and may be taken down by the same bankruptcy or another depending on whom they underwrote. A few major bankruptcies will take down the whole $58 trillion edifice like a "house of cards."

The only way to resolve this is for the U.S. government to declare "force majeure" and annul these contracts. Parties will be relatively less scathed financially as they will lose only the premium flow and un-callable protection where they have underlying securities to protect.

Dink, I went through the same panic Aug07 and moved out of the $ but it turned out to be a mistake. Although gold was only ~$640 I passed up on it (darn) but I did go 20% gold at $860 as an insurance policy, I know I could lose 20-30% on it at worst but I'm guaranteed of having something when the dust settles. If you don't want to risk holding it at home or safe deposit box (govt confiscation) the Perth Mint has free storage for unallocated gold. You get a share in a big bullion bar and if you ever want delivery you pay a fabrication fee and they can send it to you. There is also BullionVault or GLD ETF. For spending needs, silver would be more practical. Please see these two links for a useful insight on why the dollar is behaving as it is:

So it appears that you two (and Jesse) are all pro-gold. So I should swallow my pride, admit I was wrong, and figure out how to safely buy this ridiculous metal. NEVER!!! Well, maybe...

Re: govt confiscation, I just saw a documentary on Ft. Knox a few days ago. They had to build it because of the confiscation. They showed black and white footage of workers sorting through the jewelry to melt it down. How in the hell did that go down peacefully?

So, the gold price is going down because the hedge funds are selling as a last act before inevitable death. So wait until deflation is nearly done, but buy before hyperinflation starts. All you have to do is time the market and possibly flee the country under the cover of nightfall. Sigh.

Hell, I know you are not in the precious metals camp but I have not been able to understand why. Have you already written a post on why this is unlikely to be a source of protection for people looking for safety in todays deflation? Or if you have not, would you be willing to consider writing one?

So, the gold price is going down because the hedge funds are selling as a last act before inevitable death. So wait until deflation is nearly done, but buy before hyperinflation starts. All you have to do is time the market and possibly flee the country under the cover of nightfall. Sigh.

Exactly. But how to time the market? And where are you going to run to? Based on the IMF's warning today, there apparently is no safe haven. (gulp)

"The only way to resolve this is for the U.S. government to declare "force majeure" and annul these contracts. "

Well, economist, if you do that you will likely unleash a veritable army of lawsuits and destroy any hope of having functioning markets. You can only change the rules so much before you destroy the entire game the rules are meant to serve. Then again, as Hell has pointed out, the game is fatally sundered anyway, so maybe that will be one of the mechanisms that "seals the deal."

Dink and Yoyomo,

Do not be too sure that the next move up in the gold market won't be very sudden. And let me state that GLD as a proxy for the actual metal is one of my least favorite vehicles. I much prefer CEF to GLD since, to make a long story short, GLD is, in my estimation, part of the paper gold scam.

When, not if, the COMEX defaults, gold and silver will probably double within a few short days. As you know, the discrepancy between the retail PM trade and the COMEX is very large. Supply at the retail level is very constrained. Given the catastrophic condition of international finance, there is no reason to believe that the tremendous appetite for PMs will diminish. When the wholesale market suffers similar supply constraints, the COMEX will be found wanting.

Remember that commodity markets are more thinly traded than share markets and as a result, are even more volatile generally speaking. That's something to ponder when one considers how volatile the share markets have been of late.

However tongue and cheek this may be, the ability of Washington's talking heads to misdiagnose an issue is truly stunning. I sometimes think you could put a mirror right in front of these guys and they would still not be able to see themselves.

There's no hype about the retail shortage of PMshere in the States, and in, GB, for example. And there's no hype about the relative value of gold versus paper assets. An ounce of gold has held up remarkably well versus, for example, the stock market hasn't it?

Ponder how much gold it now takes to buy one share in the S&P 500 (1 oz) versus how much it took to do so in 2001. Think how much gold it now takes to buy a home, versus 2001. Wake Up!!

Furthermore, if they were selling at the level you assert in the far east that there would be no supply issues at the retail level here in the west.

Edwardo,Thanks for pointing out CEF in Canda (oversight on my part) as that is how I bought in; I figured if the govt ever called gold in it would be harder for them to confiscate foreign holdings although Perth Mint Gold Certificates are probably more secure (they don't even have to be declared, so far, on your tax forms as foreign bank accounts do).

Another way to own gold is GoldMoney.com in Jersey island in the English Channel. You get a debit card that allows you to spend your gold at any participating merchant. The problem with this set up is that US tax law requires you to declare a capital gain or loss every time you use the card so it's not popular in the US but it is gaining ground overseas.

I don't have the knowledge or skill to do either. "Mongo is pawn in game of life"- Blazing Saddles :)

Stream of consciousness-There is a LOT of gold out there (again, Ft. Knox documentary) and basing an economy on earrings and bracelets just feels frivolous. But then who am I to question the preferred medium of exchange chosen by the people I want to buy stuff from? People have loved this stuff through millenia of recorded history. But the desperation vibe I'm getting from the blogosphere feels so much like the vibe during the tech boom and RE boom ("If you don't buy MSFT/rental props now, you'll be left behind forever"). In short, PM feels bubbly. But what else is there? Anything of real value doesn't store well (energy, food, etc.). And if I buy through my retirement accounts it will be "known" so do I take the tax and penalty hit, cash the accounts out, and them buy from one of these foreign outfits? It feels so treacherous.

Inhale. Exhale. Ok, Obama wins I'll wait until his first couple months in office to review the situation. McCain wins, I'm becoming a pirate with big gold earrings, a treasure chest, and sailing to a new Port Royale.

Dink,If gold was in a bubble it should have collapsed with the equity markets but it has been holding up at ~$850+/-$75 through the worst of the turmoil. The $ is the world's reserve currency and probably will not collapse as quickly as Peter Schiff expects (especially as long as the Pentagon still has a howitzer to OPEC's head) but in a Black Swan/Mad Max meltdown (Japan, China, OPEC all abandon $) the collapse could be instantaneous.

Since no one can know what the probability (small though it may be) of that happening, it makes sense to buy some insurance against that risk. Insurance is an expense and you have to go into it with that frame of mind. If everything works out you might take a loss on your gold holdings but if TSHTF, boy will you be glad you have something still of value to help you get started again. Remember in a MadMaxWorld you will need silver for small/moderate purchases, gold will be for the big stuff.

P.S. Very short but informative essay on the struggle between the Fed and the Treasury, well worth a look:

Dink,At this point no one is advising anybody to cash out and pay penalties to get into gold. If you don't have free savings (beyond what you would need for the next two years if you lost your job) start small; find a reputable coin dealer and buy what you can afford even if you have to convince the >1/2 to scrimp. A riskier (but less contentious route perhaps) is to take a sensibly-sized loan out on your retirement account and not take the penalty hit unless you are unable to pay it back on time. If "...this sucker is going down" (to quote bush) the penalty may be suspended to allow people to stay afloat. Right now it is simply impossible to know which is the riskier path to follow (will fiat become worthless or will we wake up from this bad dream intact) so it makes sense to have a foot in each camp.

If you have a realistic chance of building your hide-away and provisioning it (freeze-dried/vacuum-packed is supposed to last at least 10-15yrs) that might be your best investment in the long run but by no means is it risk free; what if it turns out you don't need it? what if you need it before it's ready and you've wasted your assets on something that's not usable?

The Age of Certainty in America is over and we will all now live the same tenuous existence that most of the rest of the world's inhabitants experience where we don't know what tomorrow will bring. We'll just have to adjust to the new reality the best we can. As Kunstler like to say, reality will deal with us even if we don't want to deal with reality.

Don't worry, I won't let YOUR reality intrude, but thank you for the almost month old article. In the meantime, I suggest you buy gold from the the short term Thai profiteers because the Chinese are acquiring gold and silver with the intention of backing their currency, to a greater or lesser degree with it.

In the meantime, I'm just very curious what you think the way forward is for the now sundered global financial system such that gold and silver have no place in it going forward.

Yes, I do. The information that I am getting is that they have been engaged in this process for quite some time, using their massive treasury holdings to purchase PMs.

In effect they are using our worthless scrip tobuy precious metals which they will then use to transform their currency into one that will usurp the dollar as the world's reserve. Remember, these are the folks that gave the world Sun Tzsu's Art of War.

"In the meantime, I'm just very curious what you think the way forward is for the now sundered global financial system such that gold and silver have no place in it going forward."

A LONG, drawn out deflationary death spiral with government after government defaulting on their respective sovereign debt obligations -- the US government being the final defaulter.

Should the US increase its deficit spending fast enough or T holders even get the inkling of a potential Fed monetization, then the deflationary collapse will come in one fell swoop as long term T rates skyrocket putting the final nail in the coffin of private debt and equity markets.

In a fractional reserve banking system, all roads lead to the same destination -- deflationary collapse.

In order to have hyperinflation, it would be necessary for the US government to abolish the federal reserve system and simply print money without borrowing from bankers to fund its deficit spending. The bankers and their political lackeys are simply not going to allow their franchise to be destroyed.

But go ahead hang on to your precious gold and silver. The bullion banks are certainly happy to have people like you on the opposite side of the trade.

Geez, you guys, take a deep breath.Get reconnected to what you always really knew, and what the world's literature has been saying for a long time, while Wall Street fiends were busy (during all ages, moreover) get sucked up into the feeding frenzy.Real money is in things, not in currency, or in stocks.What does that mean ?You get yourself some land, if you don't have any.You invest in your vegetable garden.You buy tools to take care of your vegetable garden.Good ones. Ones that don't come cheap, because if YOU WANY THEM TO LAST FOR A LONG TIME, AND IF YOU WANT TO PASS THEM ON TO YOUR KIDS, YOU INVEST IN THEM.Maybe you buy a piano, too.Just to be able to fiddle while Rome burns. (In my case, it means playing Chopin Nocturnes while the stock market circles the toilet, as someone else here said.While you're not taking care of your vegetable garden, because it will take up most of your time if you want to be able to produce the food that you need to survive hard times.To quote someone else, whose words have come to me all too often these past few weeks :

Th'expense of spirit in a waste of shameIs lust in action and, till action, lustIs perjured, murd'rous, bloody, full of blame,Savage, extreme, rude, cruel, not to trust ;Enjoyed no sooner but despisèd straight ;Past reason hunted, and no sooner had,Past reason hated as a swallowed baitOn purpose laid to make the taker mad :Mad in pursuit, and in possession so ;Had, having, and in quest to have, extreme ;A bliss in proof, and proved, a very woe ;Before, a joy proposed ; behind, a dream. All this world well knows ; yet none knows well To shun the heaven that leads men to this hell.

William Shakespeare, Sonnet 129.Sound familiar, my friends ?I think too many people these days have been reading Friedman while neglecting Shakespeare.Sorry to keep harping, but Cassandra is an evangelist too : The Merchant of Venice has taught me what I should know about the economy.

I had a strong suspicion that when I asked you to give me an alternative scenario you would have little to offer. Little did I know that I would be arguing with someone whose perspective was that of a Marxist doomsayer.

To wit:

A LONG, drawn out deflationary death spiral with government after government defaulting on their respective sovereign debt obligations -- the US government being the final defaulter.

-Why would, for example, China, default, especially when they don't have anything like the "obligations" of the U.S. your putative last man standing. As for the "death spiral", where government after government defaults, this scenario while possible I suppose, lacks any nuance or precision.

Should the US increase its deficit spending fast enough or T holders even get the inkling of a potential Fed monetization, then the deflationary collapse will come in one fell swoop as long term T rates skyrocket putting the final nail in the coffin of private debt and equity markets.

-Believe it or not, it is not required that the equity or bond markets survive in their present form. I don't necessarily anticipate that the authorities will go Weimar since a much bigger problem than the destruction of the bond and stock markets via hyper-inflation is the loss of social stability that occurs when food doesn't stay on the shelves for more than an hour at a time as people hoard it to avoid the next upward re-pricing.

In a fractional reserve banking system, all roads lead to the same destination -- deflationary collapse.

-Other than Marx, says who?

In order to have hyperinflation, it would be necessary for the US government to abolish the federal reserve system and simply print money without borrowing from bankers to fund its deficit spending. The bankers and their political lackeys are simply not going to allow their franchise to be destroyed.

-Interesting idea, but I don't think the Fed necessarily has to be abolished to have hyper-inflation. In any case, the Fed is well on its way to self abolition.

But go ahead hang on to your precious gold and silver. The bullion banks are certainly happy to have people like you on the opposite side of the trade.

-I get the very strong sense that you believe there will be no currency of any kind, just some sort of barter economy, as we go right from fiat to folks trading tennis shoes for tire irons and bushels of wheat for bags of nails. What will you trading with?

Last I checked Marx was a Utopianist who believed the state would naturally wither away once the proletariat achieved class consciousness and took control of the factories. Nothing at all like what I anticipate is actually in store for modern civilization. Perhaps you should review Marx's work more closely.

The remainder of your argument is just as hopelessly confused and disjointed. And so I am not surprised you cling with blind faith to your "investment" in gold and silver.

I have no idea what "new" paradigm will be used to replace the old regime but I am confident that the world bankers are keen on preserving the fractional reserve system.

I highly doubt that the new world order will be the China-centric monetary order backed by gold and silver that you are apparently advocating. Somehow I think that China will be confronting its own rather unique set of difficulties going forward.

By the way, I find it a little more than ironic that you criticize me for being a doom and gloomer while you simultaneously cite an Ackerman article that states "for more than a decade, we have argued here that a ruinous deflation was the only possible outcome when the credit system finally collapsed" but posits the potential for a momentary hyperinflationary spike "laying waste to the U.S. economy in a matter of days."

What makes you a Marxist, whether you know it or not, is your belief that fractional reserve banking must end in a deflationary collapse. That idea is wholly consistent with Marxist thought. Just because you don't adhere to Marx's predicted, and most well advertised outcome, namely a dictatorship of the proletariat, doesn't disqualify you from Marxist influence.

My posting of Rick Ackerman's piece was merely for the purpose of demonstrating that whatever the outcome of the present situation, PMs will, in relative terms retain value. Management is sorry that this doesn't comport with your world view.

As for advocating China's intention to back their currency with PMs, you are confused, I advocatednothing, but rather reported on what I believe are China's intentions.

About Me

I was educated as a chemical engineer but spent almost my entire career in finance, particularly in money, FX and bond markets. The name stands for Hell-as-IOUs and the picture points to Quixotic endeavors.